It may be true that while financial advisors ultimately cannot control stock market gains — or losses — they can have a material impact on a client’s investment take-home simply by managing taxes. What may be less appreciated is that technological advancements have greatly enhanced the power of tax management.
For advisors working with high-net-worth clients, one of the most valuable roles is minimizing their tax liabilities. In a taxable investment account, one key strategy that has been gaining traction is the use of a holistic tax overlay.
When implemented properly, this approach has the potential to significantly improve clients’ after-tax returns — helping deliver real value on Tax Day and throughout the year.
Holistic Tax Overlay: Background
A holistic tax overlay is a tax management technology applied across a client’s entire taxable portfolio. It's typically used with clients who want exposure to multiple equity Separately Managed Account sleeves within a Unified Managed Account. This allows for taxes to be managed at the taxpayer level, rather than based on individual investment strategies. That is unavailable outside a UMA structure.
The overlay is intended to cover all of an investor’s taxable assets, customized to their specific tax budget and circumstances. It allows the advisor to address broad tax needs while minimizing the effects that client-specific customization requirements have on their investment portfolios.
Growth of Direct Indexing
Enter direct indexing, which has been gaining popularity among advisors due to its flexibility. Unlike mutual funds or exchange-traded funds, direct indexing gives clients direct ownership of the underlying securities in an index, creating the potential for bespoke tax-loss harvesting, customization and other benefits.
According to a recent survey from RIA Channel and FTSE Russell, 21% of advisors are using direct indexing as a strategy, while 48% plan to adopt it within the next five years.
Direct indexing can be particularly effective for tax-loss harvesting because it provides control over specific securities, making it easier to realize losses and offset gains. And it doesn’t need to be limited to stand-alone SMAs. It can be included as a sleeve within a UMA, making it a valuable component of a holistic tax management solution.
Together, holistic tax overlays, UMAs and direct indexing can comprise key pieces of the financial puzzle for many clients.
The Power of Tax Alpha
For HNW clients, tax alpha is key. While traditional alpha focuses on achieving pre-tax returns that beat a benchmark, tax alpha is about enhancing after-tax returns by minimizing the effect of taxes on the portfolio.
An effective tax overlay can often add more after-tax value than the other three sources of alpha — security selection, sector allocation and factor exposures — combined. This especially applies to asset classes like large-cap core, where it is exceedingly difficult for active managers to beat their benchmarks.
Tax management should be considered a source of alpha, and one that advisors should not overlook. It can result in more after-tax dollars for clients over time, especially when executed across all taxable investments.
Weighing Pros and Cons
While the concept of a holistic tax overlay is promising, there are a few potential drawbacks to consider. Aggressive loss harvesting introduces risks, such as resetting the portfolio’s cost basis downward.
This can reduce management flexibility and potentially lead to portfolio lock, a situation where losses are aggressively harvested until there are no remaining unrealized losses. As a result, any future trades may trigger capital gains, which can make future tax-efficient portfolio management more difficult.
Additionally, the wash sale rule limits the timing of repurchasing securities sold for tax-loss harvesting. This constraint will reduce tax efficiency if securities are repurchased too soon after being sold.
These challenges can be mitigated with careful strategy and oversight. The key is to balance the immediate tax benefits with the long-term flexibility and goals of the client’s portfolio.
Advisors should also look at what type of tax mitigation strategy is best suited for the client. Sophisticated strategies like overlay and direct indexing may make more sense for investors who need a customized experience, while ETFs are highly tax-efficient vehicles for those looking for a more standard pooled vehicle.
Implementation Process and Checklist
Given the risks, the holistic tax overlay should be implemented in a way to mitigate risks as much as possible and achieve optimal results. The overlay should be coordinated by a centralized manager who focuses on the following key tax objectives:
- Managing the account so that it is as close as possible to the target model from a risk perspective, as measured by tracking error
- Adhering to client needs through personalized tax management
- Diversifying concentrated portfolios in a tax-efficient manner
- Minimizing realization of net short-term capital gains
- Monitoring and generally avoiding wash sales
- Aiming to meet client-specific long-term capital gains tax budgets
- Reporting on the benefits of tax management at the client level
Bigger Picture
A holistic tax overlay strategy is far more than a tool for managing taxes — it's a method for creating lasting, personalized value for HNW clients. By using a UMA structure and incorporating direct indexing into the equation, advisors can offer tax-efficient investment solutions that minimize the stress of Tax Day and help clients keep more of their hard-earned wealth.
Dana D'Auria is group president, Envestnet Solutions, and co-chief investment officer of Envestnet.
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